Draft Energy Bill: Pre-legislative Scrutiny - Energy and Climate Change Contents

5   Capacity Mechanism

156.  The aim of a capacity mechanism would be to provide an insurance policy to reduce the likelihood of future blackouts and to ensure a reliable electricity supply to consumers. At the moment, generators are only paid for the electricity that they produce. A capacity mechanism would change this by making payments for the availability of capacity in order to ensure there is sufficient spare capacity on the system to avoid blackouts.

Need for the mechanism

157.  DECC believes there is no immediate threat to the security of electricity supply, with 83 GW of generating capacity available at the end of 2010 compared to a peak demand of 61 GW.[184] Beyond this its analysis suggests a risk to security of supply as a large amount of existing generating plant is due to close while an increasing amount of low-carbon, intermittent or inflexible generation is needed to meet the UK's carbon reduction targets. Renewables and nuclear plant have low running costs, and future fossil fuel plant such as gas will therefore only run to supplement this generation.[185] This will create uncertainty of revenues for fossil plant, and DECC is concerned that this could lead to under-investment and uncomfortably low levels of reliable capacity.[186]

158.  Although the central scenario in DECC's modelling indicated that a capacity problem would not occur until the 2020s, its "stress test" (i.e. worst case scenario) suggested that a capacity problem could occur in the second half of this decade.[187] DECC argued that this uncertainty meant the legal framework for a capacity mechanism needed to be put in place as soon as possible, so that the first capacity auction could be held in 2014 for capacity to be in place "by 2015/2016" if necessary.[188] Its modelling suggested that "in some years" we could see blackouts affecting up to 2.5 million homes unless action was taken.[189]

159.  The Minister told us that because DECC does not envisage the mechanism being needed "for a couple of years at least", the detail of its operation does not need to be finalised.[190] Chapter 3 of the draft Bill (Clauses 20 to 30) therefore only provides enabling powers for the Secretary of State to design and introduce a capacity market in Great Britain.[191] With many details of the market still lacking, our scrutiny of the proposals embodied in the draft Bill was unavoidably limited. However, we do have some high-level comments based upon the evidence we received during this inquiry.

Uncertainty over the mechanism

160.  The draft Bill would give the Secretary of State powers to introduce a capacity market, but these would only be used if and when Ministers decide a market is needed. This decision will be based on analysis provided by the System Operator - National Grid - and possibly other technical experts including Ofgem.[192] Although not all of our witnesses were convinced that the case has been made for a Capacity Mechanism, others were supportive.[193] In any case, there was general agreement that now the Government has proposed the mechanism, clarity is needed to avoid a hiatus in investment in new capacity.[194] Ian Marchant of SSE, for example, told us that:

the biggest issue at the moment is the uncertainty: effectively, the Government has created a known unknown. They have said there will be a capacity mechanism but not what it will be, and once you've gone down that road you've got to get it certain quickly so that any investments can be decided, because boards, my board included, will say, "We will wait until we see what that mechanism is." We have created a situation where we now need to get a capacity mechanism in.[195]

161.  The Secretary of State told us that DECC has "tried to give a very clear signal" that there need not be such a hiatus, because any capacity built since publication of the draft Bill will be categorised as "new" in any future capacity auction.[196] Nevertheless, there is a risk that the need for a capacity mechanism may now become a self-fulfilling prophesy - that an investment hiatus caused by policy uncertainty will deliver the precise capacity problem that DECC aims to avoid.

162.  We heard that a standard of reliability could provide helpful clarity over what a capacity market would be aiming to achieve.[197] This is the approach taken in some US markets, where decisions on the required level of capacity are based on a minimum standard of reliability, such as "interruption of electricity supplies due to insufficient capacity on no more than 0.1 days per year".[198] Indeed, National Grid, who would run the proposed auction, told us that "one would have to define what output we are trying to have" and that an "objective way of discussing security of supply would be useful to everybody".[199]

163.  The Secretary of State told us that he is "open-minded about the role of targets", and DECC is considering defining and using an enduring "reliability standard" to inform Ministers' decision on the amount of capacity needed. [200] However, in Annex C to the EMR Policy Overview, DECC also said that "if we did adopt a reliability standard, we would expect Ministers to retain scope for their annual decision on the amount of capacity to contract for to vary from the reliability standard to ensure that costs and reliability can be balanced". This would introduce a political element into the decision making process, which could reduce certainty for investors.[201]

164.  The deferral of a firm decision to implement a capacity market creates uncertainty and risks a hiatus in investment. The Energy Bill should be based on a clear Government position on the circumstances in which a market will be introduced, and how this will be reviewed and updated over time. The Government should set out an enduring reliability standard, which, along with a decarbonisation target for electricity, would provide a clear framework for the System Operator to work within when operating a capacity market.

Design of the mechanism

165.  There are three steps involved in the design of capacity mechanisms:

a)  Analyse the risks to reliability that the mechanism will need to address;

b)  Determine the products or services that the mechanism will need to procure; and

c)  Decide how the required products or services should be valued.

166.  We heard that the focus of debate to date has been on the third step: whether or not the System Operator should run a market-wide auction for provision of future capacity or procure "strategic reserve" capacity.[202] However, the first two steps are also important because we cannot assume that our traditional approach to ensuring reliability will be appropriate in the future, for example in the case of an electricity system with a high proportion of intermittent renewable generation.[203]

167.  In Annex C of the EMR Policy Overview, DECC said that the Capacity Market would be a competitive auction, run by the System Operator, based on a forecast of future peak demand and its role would be to deliver a total required volume of capacity defined by Ministers.[204] The European Climate Foundation told us that this "total volume" approach is based on the assumption that system reliability is most under stress at the time of peak demand, and that delivering a total volume of capacity that sufficiently exceeds peak demand will ensure reliability at all times.[205]

168.  This assumption may not hold true for our future electricity system. Modelling for the south of Great Britain has suggested that the greatest challenge to reliability by 2030 will arise not at times of peak demand, but when consumer demand and the varying output of intermittent renewable generation are changing in opposite directions.[206] This could occur at any time and to the greatest extent when demand is increasing to a maximum while intermittent generation is reducing to a minimum, or vice versa. The flexibility of the remaining capacity on the system will thus become at least as important as its total volume.[207] Other witnesses have agreed that the characteristics of capacity, such as how long it takes for it to respond and then remain available, are crucial and need attention.[208]

169.  DECC has stated that the market will not specifically contract for flexible capacity.[209] It anticipates that the electricity market will continue to provide adequate signals to bring forward the right mix of flexible capacity, and that the existing balancing mechanism will continue to ensure moment-to-moment system balancing through services such as Short Term Operating Reserve (STOR). However, DECC also said that it intends to consider this further when developing the design of the Capacity Market.[210] Indeed, the Minister told us that "the capacity mechanism [...] is actually something that needs to represent flexibility."[211]

170.  In our original EMR inquiry we said that the Government needed to analyse more fully the potential need for flexible capacity and demand-side measures at all times, not just at times of peak demand.[212] In its White Paper of July 2011, DECC committed to outlining its electricity systems policy in summer 2012, "focusing on challenges around balancing and system flexibility". It is very unsatisfactory that this policy was not published alongside the draft Bill to be available for our pre-legislative scrutiny.

171.  We are extremely concerned that the capacity market proposals are based upon out-dated assumptions and an insufficient analysis of the future risks to reliability. We recommend that the Government undertakes much clearer analysis of the problem that the capacity market is trying to solve, particularly the integration of the large volume of intermittent generation that is likely to be required to decarbonise our electricity supplies, and of the role capacity payments can play in furthering demand side response and reduction measures. The enabling legislation in the Energy Bill must be able to meet our future reliability challenges.

Minimising costs for consumers

172.  At the initial consultation stage, the Government stated a preference for a "strategic reserve" capacity mechanism but subsequently decided, in light of representations from industry and elsewhere, that a market-wide mechanism would be better.[213] However, RWE npower[214] has since told us that a reserve would be more than ten times cheaper - a cost of £300-650m over the period 2015-25 compared to £7.5bn for a market-wide mechanism.[215] DECC's own analysis, as published in its Capacity Mechanism Impact Assessment, also found a strategic reserve to be cheaper. The estimated net cost was £1.1bn over the period 2010-2030[216] compared to a business as usual scenario, whereas the estimated net cost of a capacity market was £2.5bn.[217] However, DECC did not believe that these costs were representative of the impacts of each mechanism, and so also compared them qualitatively.

173.  One of DECC's key qualitative concerns, not modelled in the net costs, was the "slippery slope" problem.[218] This would occur if, by preventing high prices at times of system stress, the strategic reserve reduced the market-based incentive for investment in new capacity. As we discussed in our previous inquiry on EMR, more and more capacity would then be required in the reserve to ensure the reserve remained effective.[219]

174.  Evidence we received suggested that if the proposed capacity market delivers insufficient flexible capacity, there is a risk that the System Operator would have to use additional mechanisms to ensure reliability, leading to unnecessarily high costs.[220] The European Climate Foundation told us that the Energy Bill should include a mandate for the Regulator to establish an incentive framework for the System Operator to minimise the costs of delivering reliability.[221]

175.  We recognise that a more thorough assessment of cost-effectiveness must await the publication of detailed capacity market proposals. DECC should conduct further analysis on the costs of the capacity market to ensure it is not significantly higher than alternative options such as a strategic reserve. The Government should clarify how the Energy Bill will ensure that the capacity delivered by auctions will have the appropriate characteristics, such as flexibility, and how this relates to the System Operator's existing system balancing role, in order to ensure that costs are minimised.

Technology options for providing capacity

176.  Clause 20(3) of the draft Bill states that "providing capacity" to the capacity market means providing electricity or reducing demand for electricity. The market would be open to new or existing generating capacity as well as non-generation approaches such as demand response, storage and interconnection.


177.  In terms of generation technology, we heard two conflicting stories of what EMR will achieve: some said not enough gas power stations; some said too many. We discuss the future role of gas further in Chapter 9 (paragraphs 221 - 223).

178.  Intergen, an independent generator operating gas-fired power stations, told us of a range of issues that need to be addressed for the capacity mechanism to support both existing and new generation.[222] Among these, it highlighted that to build a new combined cycle gas turbine takes around seven years - three to gain consent, one to tender and contract, and three to construct. If the Government identifies a need for new generation capacity this decade, Intergen's evidence suggests that it is unlikely to be brought about by capacity auctions that may or may not be held from 2014, as the Government currently suggests.

179.  Stag Energy, a company with interests in gas generation and storage, argued that it will be challenging to maintain a 15 - 20 % capacity margin without the construction of 12 - 15 GW of new gas generation over the coming decade.[223] Its analysis showed that existing coal and gas plant has "much higher running costs" than new combined cycle or open cycle gas turbines. These new, more flexible plant are more expensive to build but have a lower overall running cost at reduced levels of demand. Stag Energy warned that the proposed capacity market, with its single clearing price model, risks penalising new, more efficient plant while rewarding existing plant.[224]

180.  Indeed, experience in the USA suggests that while capacity markets are attractive to existing resources, they do not encourage investment in new generation. The New England 2010 Annual Report notes that with the looming possibility that some of the region's older resources will retire, the ability of its capacity market to attract timely investment in new generation "remains largely untested".[225]

181.  The Committee on Climate Change has said that investment in around 10 GW of new unabated gas generation over the next two decades, and a total gas-fired capacity of 30 GW in 2030, would have an important role in balancing intermittent renewable generation by generating at low annual load factors (less than 10% on average in 2030). However, the Committee has expressed concern that EMR proposals - particularly the Emissions Performance Standard - will allow a greater role for gas generation.[226] It said that if 30 GW of gas plant were to generate at baseload (i.e. the majority of the time) in 2030 instead of only as balancing plant, average emissions would be 200 gCO2/kWh - well over what we need them to be to meet our statutory carbon budgets.

182.  A number of our witnesses shared the concern that EMR, as embodied by the draft Bill, will lead to a "dash for gas" that will make it harder to achieve our statutory emissions reduction targets.[227]

183.  As we recommend in paragraph 223, it is vital to have an understanding of the likely impact of EMR of the future role for gas generation. DECC should conduct modelling work to assess the combined impact of the capacity market and the EPS on emissions and security outcomes under different scenarios. This should include both a "dash for gas before 2015" scenario and a "no new gas before 2015" scenario

184.  Related to the issue of new investment in generation Stag Energy highlighted the need for gas storage, both to ensure security of supply and to minimise fuel price volatility.[228] In our energy security inquiry, we concluded that the UK needs to significantly increase its gas storage capacity.[229] We recommend that the Government, in its forthcoming Gas Strategy, considers the interrelationship between electricity market reform and the capabilities of the gas infrastructure, in particular the potential need for more gas storage.


185.  In the supporting documentation to the draft Bill, DECC says it is keen that non-generation technologies and approaches, such as demand-side response, storage and interconnected capacity, "can play a fair and equivalent role to generation in a DSR Capacity Market".[230] However, many of our witnesses criticised the draft Bill and its supporting documentation for its lack of detail on these approaches.[231]

186.  Friends of the Earth told us that:

it is unlikely that the existence of a capacity market alone will provide sufficient incentive for investment in innovative storage and DSR technologies to be developed to the point that they can deliver capacity with complete certainty and be bid into a capacity market auction at a cost that can compete with established fossil fuel supply technologies. Getting technologies to this point requires significant R&D, early deployment support and preference within the capacity market.[232]

187.  Green Alliance reported that experience from the USA demonstrated the risk that the market would not incentivise innovative technologies like demand-side response. It said that in the USA's PJM market:

much of the capacity payments initially went to existing fossil power stations and a 'clean first' priority system had to be introduced to ensure that DSR was able to compete fairly. As with demand reduction, given the immature nature of the demand response market, it is likely to be necessary to proactively seek out demand response to ensure that the maximum economic level of DSR is developed.[233]

188.  A number of our witnesses agreed that, as innovative technologies, DSR and storage would need support to enable them to develop and compete in the market.[234] This could be achieved by amending the Bill to require the System Operator to procure minimum volumes in the capacity auction, and/or to seek out and prioritise them over other approaches.[235] Such support would help kick-start the market in the provision of these services and ensure the System Operator develops the necessary systems and expertise to exploit the benefits of demand response.[236] RWE npower told us that it is vital that the legislation sets out a clear mechanism for the demand-side to contribute, because otherwise the £12bn that energy companies will invest in smart meters (ultimately at consumers' expense) will be a substantial lost opportunity.[237]

189.  However, two of our witnesses did not think extra measures to support demand-side measures were necessary in the Bill, since it is already complex and because demand-side policies exist elsewhere already.[238] Professor Newbery also warned us of "unsubstantiated claims that all demand-side is necessarily cost-effective".[239]

190.  On storage specifically, the Electricity Storage Network (ESN) highlighted that existing legislation does not explicitly define or address the role of storage in the electricity market, and that this causes confusion and uncertainty about its treatment.[240] The ESN suggested that it is not appropriate to include electricity storage simply as a generation activity, as it can provide other services such as absorbing power at times of excess production by wind and other intermittent generation. ABB, with experience of deploying the UK's first battery energy storage device, also identified "significant legal challenges" that need to be overcome in relation to the treatment of energy absorption and resupply to the grid.[241]

191.  As innovative technologies, demand-side response and storage technologies should be recognised and defined explicitly in the Energy Bill. Support for innovation is given to the supply-side, for example by the banding of the Renewables Obligation, and the Bill should provide similar support to demand-side and storage technologies. DECC should investigate the legislative and other barriers to storage identified by our witnesses, and remove any that prevent it from competing fairly in the market.

192.  Witnesses warned that it is unclear how the proposed capacity market would work with the move to a more integrated European electricity market, and potentially larger balancing areas. Simon Skillings told us that if a neighbouring market does not have a margin of spare capacity, "all that happens is that you need to keep running to stand still, because every time you build something to get your margin, they will shut something next door to keep their price going up".[242] This is another area the Government said it is considering as part of its detailed design work for the capacity market.[243]

193.  The Government should clarify how the capacity market will be made compatible with increased interconnection and the move to a more integrated European electricity market.

184   DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, p 4 Back

185   Steggals W, Gross R, Heptonstall P, Winds of change: How high wind penetrations will affect investment incentives in the GB electricity sector, Energy Policy, 2011, Vol:39, Pages:1389-1396 Back

186   DECC, Electricity Market Reform: Policy Overview, May 2012, p 15 Back

187   DECC, Electricity Market Reform - Capacity Mechanism , Impact Assessment, IA No: DECC0076, 15 December 2011 Back

188   DECC, Electricity Market Reform: Policy Overview, May 2012, p 16 Back

189   DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, p 5 Back

190   Q 399 Back

191   Note that capacity payments already exist for Northern Ireland, as part of the all-Irish Single Energy Market Back

192   DECC, Electricity Market Reform: Policy Overview, May 2012, p 16 Back

193   Ev 178, Ev 206, Ev 151, Ev 193 Back

194   Ev 206, Q 1 [Ms Vaughan], Q 2 [Mr Marchant] Back

195   Q 2 [Mr Marchant] Back

196   Q 528 [Secretary of State] Back

197   Ev w143  Back

198   DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, p 10 Back

199   Q 338 Back

200   Q 386; DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, p 10 Back

201   Ev w64 Back

202   Ev w143 Back

203   Ev w143 Back

204   DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, pp 5-11 Back

205   Ev w143  Back

206   Ev w143 Back

207   Ev w143 Back

208   Ev w14, Ev 193, Q 140 [Professor Newbery]; Oral evidence taken before the Energy and Climate Change Committee on 25 January 2012, HC (2010-12) 1781-i, Q 2, Q 29 and Q 30 [Ms Kruisdijk] Back

209   DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, p 11 Back

210   DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, p 11 Back

211   Q 538 Back

212   Energy and Climate Change Committee, Electricity Market Reform, para 192 Back

213   Oral evidence taken before the Energy and Climate Change Committee on 25 January 2012, HC (2010-12) 1781-ii, Q 116 (Mr Hendry) Back

214   Memorandum submitted by RWE to the Energy and Climate Change Committee, Electricity Market Reform Technical Update, EMRT 07, section 15 Back

215   Present Value 2015 to 2025, real 2010. Back

216   DECC states that "all costs occur between 2024 and 2030 because that is when a Capacity Mechanism would be triggered under the central scenario." Back

217   DECC, Electricity Market Reform - Capacity Mechanism , Impact Assessment, IA No: DECC0076, 15 December 2011, p 22 Back

218   DECC, Electricity Market Reform - Capacity Mechanism , Impact Assessment, IA No: DECC0076, 15 December 2011, p 36 Back

219   Energy and Climate Change Committee, Electricity Market Reform, p 51-52.  Back

220   Ev w143 Back

221   Ev w143 Back

222   Ev 193 Back

223   Ev w14 Back

224   Ev w14 Back

225   ISO New England, 2010 Annual Markets Report, 3 June 2011, p 21  Back

226   Committee on Climate Change, 27 March 2012, Public letter from Lord Adair Turner to the Secretary of State Back

227   Ev 137, Ev 172, Ev w94, Ev 187, Ev w133 Back

228   Ev w14 Back

229   Energy and Climate Change Committee, Eighth Report of Session 2010-12, the UK's Energy Supply: Security or Independence? HC 1065, October 2011 Back

230   DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, p 16 Back

231   Ev 137, Ev w37, Ev w50 (Association for the Conservation of Energy), Ev 172, Ev w86, Ev 187, Ev w142, Q 2 [Mr Marchant] Back

232   Ev 137 Back

233   Ev 172 Back

234   Q 135 [Mr Skillings] Back

235   Ev 127, Ev 137, Ev w37, Ev 172, Ev w143 Back

236   Ev w143 Back

237   Ev 178 Back

238   Q 135 [Professor Newbery], Q 235 [Ms Kelly] Back

239   Q 135 [Professor Newbery] Back

240   Ev w118 Back

241   Ev w86 Back

242   Oral evidence taken before the Energy and Climate Change Committee on 24 January 2012, HC (2010-12) 1781-i, Q 7 [Mr Skillings]  Back

243   DECC, Electricity Market Reform: Policy Overview, Annex C, Electricity Market Reform: Capacity Market-Design and implementation update, May 2012, p 16 Back

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Prepared 23 July 2012